The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Monday, July 15, 2013

John Authers on best case for reviving Glass-Steagall

In his Financial Times column, John Authers looks at why Glass-Steagall should be revived and finds that the compelling reason for reviving the Act is it was accompanied by 7 decades of financial stability with few, if any, bank runs and economic growth.

Unfortunately, this falsely attributes to Glass-Steagall the stability that transparency brought to the financial system.

Our current financial crisis occurred and is still occurring in all the opaque corners of the financial system. Opaque corners of the financial system include banks and structured finance securities. For example, the unsecured interbank lending market froze and has remain frozen. Or for example, despite 5 years of monetary policy designed to get investors to chase yield, the market for new private label RMBS deals is a rounding error compared to its peak size.

On the other hand, the transparent parts of the financial system continue to operate without the need for government intervention. An example of this is the global stock markets. For every seller, there has been a willing buyer. The price might not have been what the seller wanted, but there was a buyer.

Am I saying the industry structure had no impact on the degree of transparency in the financial system?

No. I am saying that the change in the industry structure as a result of repealing Glass-Steagall had a negligible impact, but the structure itself had a big impact.

At the time Glass-Steagall passed, the standard for banks was to disclose their current exposure details. Ultra transparency was seen as a sure sign of a bank that could stand on its own two feet.

This all changed with the introduction of deposit insurance and bank regulators who had access to all the current exposure details on a 24/7/365 basis.

Since the regulators were already getting this information from the banks, the SEC asked the regulators whether the banks needed to continue to provide this information to all market participants. The regulators answered no.

As a result, over time banks became "black boxes" and were no longer subject to market discipline (it takes a long time to go from providing a sure sign of the ability to stand on your own two feet to acceptance of the idea that hiding behind a veil of opacity is acceptable).

So from a historical perspective, banks become opaque black boxes while Glass-Steagall was still in place.

Next, we have the emergence of securitization. Securitization, packaging loans into securities that were purchased by investors, also arrived while Glass-Steagall was still in place.

Initially, securitization was confined to assets backed by a government guarantee (think GSEs). As a result, transparency into the performance of the underlying collateral was unnecessary. The risk of credit loss was borne by the government.

Unfortunately, this lack of transparency carried over into non-government guaranteed asset classes (think sub-prime mortgages). Here, the investors needed observable event based reporting under which any activity like a payment or delinquency involving the underlying assets was reported before the beginning of the next business day so that the investors could know what they owned or know what they were buying.

Ironically, securitization with its opaque securities helped to drive repeal of Glass-Steagall. Quite simply, Wall Street used securitization with its cheaper funding to take away the lending business from the banks. Wall Street financed firms to originate the assets that were packaged into the securities.

Repealing Glass-Steagall let the banks compete on a level playing field and steal business from Wall Street (or at least that was the theory).

Am I saying that transparency is the only cause of financial stability?

No.

What our current financial crisis has shown is in the absence of transparency complex regulations and regulatory oversight doesn't lead to stability.

There is nothing surprising about this finding. Regular readers know that our financial system is built on the FDR Framework which combines the philosophy of disclosure with the principle of caveat emptor (buyer beware).

Transparency is the foundation that allows regulation and regulatory oversight to contribute positively to financial stability.

Finally, as I have said before, I can support a return of Glass-Steagall if the result is that it weakens the financial industry's lobbying power so that banks are required to once again provide ultra transparency into their exposure details.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.